Rob Swystun Pristine Advisers
You can file this particular study under “C” for counterintuitive.
While you may think that more disclosure about CEO compensation would prompt lower CEO pay, you’d be wrong, according to a study by three professors at the University of Cambridge.
[Pause for head scratching and quizzical looks.]
”We consistently find evidence that supports the argument that compensation consultants are hired to justify higher CEO pay to the board, shareholders, and other stakeholders,” wrote the study’s authors, Jenny Chu, Jonathan Faasse and P. Raghavendra Rau.
The study, Do Compensation Consultants Enable Higher CEO Pay? New Evidence from Recent Disclosure Rule Changes (September 23, 2014), found that companies hiring compensation consultants for the first time show a 7.5% increase in CEO pay compared to other firms. Also, companies where the CEO gets a pay raise are less likely to turn over consultants the following year.
Wait … it gets worse.
When the CEO him or herself was left in charge of hiring a compensation consultant rather than the company’s board (who you’d think should be in charge of something like that) it led to a 13% increase in pay.
The researchers examined more than 1,000 US companies from 2006 to 2012 and found that compensation consultants have an increasing influence inside boardrooms. That increasing influence has unwittingly been inspired by a rule change from the Securities and Exchange Commission back in 2009.
Y’see, because many compensation consulting companies also offer other services, the SEC was concerned that these consulting companies might try to actively get a raise for the management of their client companies. This would make them look good in their clients’ eyes and theoretically lead to their clients hiring them for the other services they offered.
To combat this, the SEC implemented a rule say that consulting companies had to disclose their fees … but only if they offered other services.
But, as the study’s authors write: “… the SEC rule change didn’t work as designed, because both company management and pay consultancies have found ways to circumvent the intent of the new rules.”
In other words: greed finds a way.
The answer to the SEC’s rule change was for a bunch of companies that solely offered compensation consulting to pop up. Because they don’t offer other services, they don’t have to disclose their consulting fees.
So, what we’ve learned from all this is that increased transparency is … a bad thing, I guess?
One of the problems with rapidly rising (and mostly unchecked) CEO pay is that, as Sorkin points out, it’s not really based on true market value. Therefore, it’s rather difficult to know exactly what to pay them.
The way Sorkin says boards tend to think about CEO compensation runs counter to the common sense approach of hiring people at the lowest possible cost while still paying them enough to do the best job possible and keep them from leaving, thus maximizing the money they devote toward compensation.
Boards tend to believe the best CEOs make the most money, so if they want the best CEO, they have to throw wads of cash at them so they’ll either accept or stay in the position.
Essentially, boards use compensation to “prove” to shareholders that they have a great CEO. The more they make, the better they are at their job, right?
As depressing as it sounds, with compensation consultants who don’t have to disclose their fees using the available information about compensation to get their clients the maximum amount of pay, the likelihood is that CEO pay will not only continue to rise, but probably do so at an ever greater pace.